Regulations failing debenture investors

Date: November 19 2012

John Collett

Once again questions are being asked about whether more could have been done to protect small investors after yet another debenture issuer has hit the wall. The collapse last month of Banksia, in which about 3000 investors face losses of up to $650 million, is just the latest in a long line of failures of high-yield, property-backed debenture companies extending back to 2007.

What the latest collapse confirms is how the "anything goes, just disclose regulatory regime is failing investors. These failures will not have been of much surprise to the regulator, the Australian Securities and Investments Commission (ASIC), which has been grappling with the problem of debenture issuers since at least 2002, when it first pulled up debenture issuer Fincorp. It went to Fincorp a further five times to try to force the company to improve its disclosure over claims that its investments were safe and secure. The game of cat and mouse between the regulator and Fincorp went on right up until 2007, when Fincorp collapsed with losses of $200 million.

But the advertising of debentures on radio and television as bricks-and- mortar investments paying more than term deposits is always likely to have more influence on unsophisticated investors than the risks the issuers must now provide in their disclosure documentation.

The regulator has done much since 2008 to better protect investors. Its work has been among those debentures that are unlisted and unrated.

Listed securities are relatively liquid and a debenture that is rated by a credit rating agency gives some level of comfort to investors. But the regulator appears to have exhausted what it can do under the current laws. It has cracked down on what can be said in advertising. Debenture issuers are no longer able to get away with saying the investments are "safe" or "guaranteed". And the regulator now forces issuers to answer a series of questions in their disclosure documents such as whether there are any related-party transactions and whether the issuer is undercapitalised.

Depending on the answer, the issuer has to give its reasons. But ASIC's approach is limited to being almost all about disclosure. If the issuer is under-capitalised, for example, ASIC cannot stop the issuer from continuing to raise money from the public. Many unlisted, unrated debenture issuers are still operating that do not meet all of the regulator's benchmarks. It doesn't mean those without a tick against every ASIC benchmark will fail. But these investments are always much riskier than money in term deposits with banks, credit unions and building societies, where the first $250,000 is covered by the federal government's deposit guarantee.

Lending for property development is always risky. Developers usually have to borrow at higher interest rates because banks will not lend to them. Or they will lend only so much and have first call on the money if anything goes wrong. That leaves the debenture holder exposed to the riskier funding gap and further back in the queue to get their money back. Unlike banks, building societies and credit unions, debenture issuers are not regulated by the Australian Prudential Regulation Authority and no prudential standards apply.

ASIC is not a prudential regulator; its role is to enforce disclosure requirements. But there are signs ASIC is preparing the way to recommend changes to the law to prevent those not meeting minimum standards from raising money from the public. ASIC says it will establish a "task force" to review Banksia and the regulation of unlisted, unrated debentures. It says the task force's work may involve making recommendations to the federal Treasury about law reform, "given we have pushed the existing conduct and disclosure regime to its limit".

The warning signs are there among the disclosure documents of the debenture offerers for anyone who wants to look. One of the key warnings signs is bad debts. But the danger signals in the Banksia disclosure documents, for instance, would not have meant much to unsophisticated investors, many of whom live in regional Victoria where Banksia operated.

After the failure of Fincorp and Australian Capital Reserve, which also failed in 2007, ASIC commissioned a researcher to "profile" debenture holders to understand how to better protect small investors. The profiling found the typical investor in Fincorp and Australian Capital Reserve was aged 64, and was attracted by the perceived security, rate of interest and capital protection of the investments. Most investors were also found to be educated to only high-school level, to be retired, seeking income and receiving some form of government support. There is a point beyond which debenture issuers should not be allowed to take money from the public and that is if the issuer does not meet all of ASIC's benchmarks.

If the law cannot be amended to allow ASIC to stop debenture offerers playing fast with other people's money, then consideration should be given to handing regulation of them to the Australian Prudential Regulation Authority.